Thoughts from Madrid

Macro Man has spent the weekend in Madrid, which is salubrious an environ as any other in which to digest the momentous developments of the past week. While things do seem to be changing at the speed of light, he does have a few thoughts about where markets go from here.

The first and perhaps most important of these is that global equities remain in a bear market. Global growth continues to slow and earnings expectations continue to look overambitious in many markets. One little note that flew around the market on Friday night highlighted that the stunning turnaround on Thursday and Friday simply took many assets back to their closing levels of the previous week. While Macro Man has long thought that some sort of fiscal solution was necessary to end the current crisis, it is by no means a sufficient solution to kickstart a new bull run. Ultimately, the market needs that greatest of all healers, time, to do its thing before Macro Man will be ready to contemplate strategic longs in stocks.

Between now and then rests what is likely to be a hard slog of treacherous trading conditions. Fortunately, we're all get used to trading those kinds of markets, as "treacherous conditions" is a pretty apt description of the last year or so.

That having been said, there remains ample scope for a further tactical rally within the broader bear market. Whether such a rally actually materializes is, of course, another question; frankly, Macro Man isn't sure. His portfolio risk has been reduced accordingly, as he wouldn't be surprised to see equities end the coming week up five eprcent or down five percent.

Such short equity risk that he does retain remains concentrated in Europe. While the ECB's intransigence in the face of changing circumstances drew a surprising number of defenders in the comment section of Friday's post, Macro Man is frankly happy for it to continue; equity shorts are always easier to run in the face of unforgiving monetary policy.

To be sure, the rising tumult of regulatory backlash against short-sellers and hedge funds, which resembles nothing so much as a cartoon mob armed with torches and pitchforks, makes Macro Man glad that he does not deal in single name securities. The squeeze potential in single names, both from regulatory diktat and ongoing issues surrounding Lehman-facing trades, appears to be substantial.

It looks increasingly likely that the market will have another go at the dollar. It is pretty hard to construe the implosion of the US financial system and socialization of the associated costs as anything but a negative for the dollar. With central bank swap agreements in place, foreign banks may now be able to borrow dollars again, rather than being forced to purchase them in the open market. Moreover, the market may retain a desire to price in a small chance of additional Fed cuts, though if the SPX rallies another 100 points then hikes will likely re-emerge in short-end pricing.

You'd have to think that the Paulson Plan should eventually steepen the US yield curve, though perhaps not as much as in previous cycles. A steeper curve is clearly beneficial for banks, but if the US wants to kick-start prudent mortgage borrowing again, having long-term rates at too high a level will be a negative. In any event, Macro Man lives in hope that markets re-introduce a term premium into the US government and swap curves.

Ultimately, the market's mision is to get through the end of the year alive. While last week saw the price of many major financial indicators largely unchanged, Macro Man wouldn't be surprised if there was a large pile of money lost in the process. Although circumstances can obviously change, from Macro Man's perch the next few months are likely to be all about opportunistic trading, taking the other side of panicked pricing a la the RMB one year forwards last week. This naturally lends itself to a lower risk budget than normal; and hey, if last week is anything to judge by, you're likely to be taking more risk than you think when you put on a position.

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I think that we have to acknowledge that Hanky Panky pulled out the Big Bertha on this one. There is no more rabbits to pull out of any apertures.Whatever happens happens, and if the TBT is up ten percent on the last two trading days, the dollar is going to happen. Sure the Swiss Bank is still throwing good money after bad at Uncle Buck, however Mrs. Watanabe has had her fill. Am I the only one who thinks that the IRS made the Swiss Bank an offer they could not refuse. Like the young trader, I wish I had retired. Instead I have come to be better friends with the staff at the local watering hole. Long crude, for at lest the next ninety minutes.

Back to Friday's post: ECB policy resembles that of a broken clock that twice a day points to the right time - if you sit tight like traffic lights in the middle of the crossroad, no doubt your policy target rate will prove to be properly set, sooner or later!

Have a nice day, AT

PS: Hammers to bid up to €10 mio for Montolivo? That's not the way to be good friends, dear MM!

Macro view of this post was terrific and helpful as I look out over the remainder of the year. (Similar to anon 7:10 I have a 90 min short focal length as well.) Understanding the USD's performance is what eludes me. Even before HP's rescue plan, the strength of the USD didn't line up with the US debt levels and economy. Much talk this am about GS Bank USA-- which seems to be the ultimate defensive move. Meanwhile, lots of folks in Congress indulging in schadenfreude. Let's hope they also succeed in getting the HP plan passed.

MM: I want to reiterate the offer to give Europe Bernanke, Paulson and Cox. Send us JCT or not, we don't care, just take the terrible three as far away from the States as possible.

I have yet to hear an intelligent answer, from anyone, about why deep pocketed, smart, long term investors like Warren Buffet or the long list of private equity firms (eg Blackstone, Carlyle Group, etc) do not jump in and buy the allegedly "cheap" assets that Henry Paulson is proposing to buy.

Merrill Lynch had no trouble unloading a huge pile of their bad assets -- at 15-20 cents on the dollar. There is only a shortage of buyers at the fantasy prices that banks currently have their assets marked at.

There is no liquidity problem; banks just refuse to accept responsibility for their bad trades. We all learn as traders that your first loss is your best loss -- but in the face of losses these "titans" of finance repeatedly doubled down... and now they are bankrupt.

The Fed's terrible lending policies are allowing the fantasy marks to continue -- that isn't a liquidity issue, it is a state of denial.

If Paulson's plan actually comes to be, it has to follow one of three scenarios:(1) The Treasury buys the assets at a price that allows the taxpayer to profit... I still want to know why the smart money like Berkshire and Carlyle are passing on this "opportunity"(2) The Treasury offers a correct price for the assets, but the banks opt not to participate because it would force them to recognize their losses and their bankrupt status(3) The Treasury overpays for assets and ends up losing hundreds of billions of taxpayer money.

Given the investment history of Buffet / Blackstone -- and their decision to pass... and given the government's history of continuously losing money, I feel very safe ruling out scenario #1

and scenario #3, the taxpayer takes a bath... Uncle Sam already has trillions in unfunded entitlement programs, two on going wars, and a perennial $400 billion deficit. Its hard to see how Uncle Sam keeps a AAA rating given the above -- so how does he keep it if he loses another trillion on a disastrous bailout plan?

Henry Paulson spent the summer of '07 telling us the sub prime problem was well contained. He spent the summer of '08 telling us that Fannie and Freddie were perfectly solvent and in no need of capital.

Now he is telling us he can correctly price assets that no one else is able to, and persuade the banks to sell at those prices even though it means their insolvency.

Gramps, well, for one thing Buffett and the PE guys don't have enough money to buy all of the crap, even at discounted prices.

As for JCT, if he is to be judged by his sole point on the compass, then he is an utter, abject failure. European CPI has consistently printed above his target during the past several years, and policy rates are barely even positive when compared to current CPI inflation (which, given JCT's inability to look for than five seconds into the future, must be the appropriate measure), which would seem to be a laughably accommodative stance for such an apparent champion of guarding the euro's value.

If, as his defenders believe, he should not be worried about the economic cycle, why do they not castigate him for not putting rates up to the degree that domestically generated deflation offsets imported inflation? Or could it be that the cycle does matter, after all?

As noted previously, just because the penny hasn't dropped for European banks doesn't mean the penny doesn't exist. Indeed, on a forward looking basis I see more downside for European financials than their US counterparts.

And while the new US and UK regulations are lamentable, let's not forget that Europe got there well in advance; just ask anyone on Citi's European government bond desk how "free" the Bund market is, for example.

MM: I'll give you that Buffet et al do not individually have the money to buy all the crap, but in aggregate they might.

More importantly is the fact that they don't want any of the crap. If there were good deals to be had, you might think they would at least "cherry pick" the assets?

The truly smart guys (as opposed to the ones with big egos) know they have absolutely no way to make an educated guess, never mind a true analysis, of what these assets are worth.

It simply strains all credibility to believe politicians will do better.

I will concede to you on JCT's performance. As you probably guessed, I was arguing that JCT is the lesser of evils -- at least when compared to the three stooges we have in the U.S. I can only applaud Trichet's courage not to promote ever increasing amounts of debt by lowering rates.

I agree that the shoe hasn't dropped (yet) on European banks.

I think our children will pay dearly for our desire (not need) to spend way beyond our means.

Lower rates can not promote true economic growth unless people have more income to pay the additional debt -- which we don't, as a nation can't even pay our existing mortgages never mind new debt.

As you walked around the Plaza Mayor and the rest of Hapsburg Madrid, I guess you were conscious of the interesting parallel of the 1576 default with the current conundrum - an unwinable war, the educated class exclusively dedicated to lobbying, paper shuffling and bookkeeping, the importing of everything, and the betrayal of the future that was the spending of all of the non-infinite production of Potosí.

MW: I am not sure what to say about Ireland and Spain -- although I would argue they are a mistake caused by the EU, not by Trichet. Europe's economy is not uniform or integrated (even now). Lowering rates a few years back to promote growth in Germany/France/Italy arguably over stimulated Ireland and Spain -- and now Europe is paying the price.

In any event, I already conceded on Trichet. I was only suggesting that he is no where near as bad as Bernanke / Paulson / Cox.

My argument is that the U.S. does not need any more debt. We have way way way too much already.

CB, the thing that actually struck me about Habsburg Madrid was a) how exceedingly unpleasant looking Philip IV was, and b) that they must build a new wing to Banco D'Espana with every financial crisis, given the enormous size of the building. I could swear I saw some cranes arriving from Dubai....

@gramps: are you really sure about JCT' courage and intransigence?Measured y-o-y at the last reporting date, the FED's balance sheet was larger by 3.1%, the ECB's by 22%.The FED, until a few ago, unlike ECB, is shrinking its US goverment securities holdings...ECB is printing...Watching M2, the only comparable money aggregate, since 2003 in US has grown 26%, in Europe 51%: it's double!!!!JCT is redirecting attention to matters in which he has no control, but he's not acting on its huge balance sheet.

About interest rate, i know that 4.25% it's a ceiling, then we can discuss to infinite and anyone can think differently..

Its great that M2 has grown by whatever rate in the U.S. versus Europe, but the numbers are not very meaningful in either economic region -- and certainly not comparable.

My argument was ONLY that Bernanke (unlike Trichet) decided to bail out Bear Stearns in a manner that puts $29 billion of taxpayer money at risk.

Bernanke has taking a sterling Fed balance sheet, 100% US Treasuries -- and replaced it with something that is about 45% Treasuries, 55% crap that no one else wants or will even finance.

Paulson is now proposing to turn the US Treasury into the world's largest and most speculative hedge fund.

The fact that smart money (Buffet, Carlyle, Blackstone) have passed on this "lucrative" opportunity strongly suggests it isn't very lucrative at all. The smart money won't even cherry pick assets out of the crap.

The banks are woefully undercapitalized, and investors understandably don't want to lend money to people who have demonstrated such poor (non existent?) risk management skills.

Paulson's plan cannot help the banks, unless he overpays for assets-- meaning the taxpayer takes a massive loss.

These failed banks stand to get a windfall, to be paid for by taxpayers who acted prudently.

Name a successful sports team that promotes its worst players while benching the best and the average players?

Paulson's plan defies common sense, never mind economics. It is anti-meritocracy.

M2 was a good measure historically of money supply -- but the proliferation of non-bank banks (GMAC, Dietech, GE Capital) and the securitization of loans has completely blurred the line between traditional reserve banking and investment markets.

The money multiplier becomes theoretically infinite when you have significant players in the market that do not have to keep a reserve balance at the central bank.

Actually, the BDE building is from the 1880's (oversexed Bourbon simpletons by then in control) - a monument to times long past and never to be repeated. You say they're adding on... Don't like the omen.

I agree that the FED really needs to overpay to improve the banks balance sheets. However it is possible that takeing some of the crap of the balance sheets could also improve the borrowing costs for the banks who do deceide to accept a sale. In other words the loss of selling below bookvalue could be offset by lower credit spreads and higher margins for that particular institution. If your cost of raising capital drops by a whole percent or more it is going to make a difference to your earnings, hence there might be som incentive to get rid of the worst crap at prices that make sence to both parties.

I am intrigued by your comment: "just ask anyone on Citi's European government bond desk how "free" the Bund market is, for example". Care to at least hint at what you mean?

I think you should give Trichet a break. Perhaps he should have raised the ECB repo rate higher to be rigidly true to the ECB's stated principles, but without more political support, the result might well have been the emasculation of the ECB, and even higher inflation. Duisenberg might have done though.

RE, this link provides a bit of background, though I'd forgotten that it was the FSA that actually got their knickers in a twist.

With respect to JCT, I do think that the ECB has broadly done a better (if more irritatingly smug) job than the US authorities, at least up until a few months ago.

However, their recent rhetoric suggests that they are ill-equipped to deal with changing circumstances...at which point their smugness will come back to haunt them.

As I have disclosed before, I am short European equities, so it is more than OK with me if the ECB wants to fixate solely on backward looking data.

Ultimately, this crisis will expose the weaknesses of both monetary union (one size clearly does NOT fit all) specifically and inflation targeting more generally. I think that guys like Bollard and Stevens have performed much better in the last couple of years than Trichet, and without the simpering displays every month. (I used to gag at Greenspan's lecturing testimonies as well, FWIW.)

Gramps, any chance of condensing the posts? There is too much to read these days and, while you make some good points, it's never easy finding needles in haystacks. PS Keep up the good research and I hope you pass your degree.

I keep wondering when the argument will mature past the just one more hit, just one more hit! Please I need it!

As an irish man, I can easily see the problem here. It's called affordability. And it has little to do with interest rates. We've had the british and american economists/press for years telling us that deregulation was the panacea to all ills. Privatise and deregulate. And guess what, we went from having mortgages of 3.8 times income as an average in 1990 to 10 times income in 2007. It's not a surprise we're in the mess we're in. And if we can't handle 4% interest rates it's an even bigger mess than we know.

To be honest I think JCT has done the best he can do, which is little at all. Too much tightening and the euro goes stratospheric, too little and well, there's that compass. He's been hamstrung by the FED, that venerable institution run by free market zealots. Drug dealers to monetary parasites.

17 years the US dream of rabid capitalism. 17 years longer than the soviet union. But yeah, it's JCT's fault.

Thanks MM. I thought you were implying that the German authorities were fixing the bund market (which would be news to me), but I see you were referring to Citi's abuse in 2004. I have not studied the case in detail, but it struck me at the time that it was more a case of anti-social behaviour by Citi's traders than lax regulation (ie they abused MTS rules that were intended to ensure that all market makers played their part in keeping the market liquid).

RE, my memory was faulty; I thought it was the ECB, not the FSA, that censured Citi.

In any event, it's hard for me to accept that Citi did anything wrong when Voldemort and pals have done the same thing with regularity (though lss so in the past couple of months, I'll concede) in foreign exchange.

a) Europe, rather than the US, is now China's largest trade partner, a fact that has emerged in conjunction with the steady appreciation of EUR/RMB (itself at least a partial product of PBOC's direct market activities.) In that vein, China's FX policy could, I believe, be construed as mercantilist in the 18th century sense. I will concede, however, that the object of their FX activities has more to do with maximizing employment than wealth.

b) The real point of my jibe was decidedly micro rather than macro. The trading style of Voldemort (i.e., the way they execute their business in non-Chinese currencies in the open market) on occasion bears a striking resemblance to that for which Citi was censured a few years ago.

True, FX is an unregulated market, so FSA rules don't apply. Still, it's hard to cry too many tears over Citi's behaviour when their and other FX desks have been on the receiving end of similar behaviour from a sovereign entity.